“Woe to the land whose king is a child and whose leaders are already drunk in the morning. Happy the land whose king is a nobleman, and whose leaders work hard before they feast and drink, and then only to strengthen themselves for the tasks ahead”. (Eccl 10: 16-17)

"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput

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Saturday, March 19, 2011

When Theory and Real Life Collide - thoughts on the Yen

In response to some private emails as well as a couple of comments from my recent articles on the Yen intervention, I thought it worthwhile to deal with what I believe is a clash between theory and the real world.

What I am referring to are articles written by two men, both of whom I greatly respect, who argue that the Yen should be permitted to rally instead of being undercut by a coordinated G7 intervention effort. The claim is that a strengthening Yen would be beneficial to the Japanese since they are going to require massive amounts of raw materials with which to rebuild their battered nation. This strength would outweigh any competitive advantage gained through a weakening of the Yen which would aid the heavily export-dependent Japanese economy or so they claim.

Let me first of all state that I believe that a nation's long term economic strength can only be maintained if it possesses a strong currency. The idea of deliberately short-circuiting one's own currency in an attempt to ramp up exports is harmful in the longer term as it tends to increase the price of all imported goods coming into that nation and as such is normally inflationary, all things being equal. That eventually works to undercut the quality of life in that nation and weakens it in the long run.

That being said, the real world functions not on theory but on practice. We do not yet live in a perfect world, where every nation lets its currency move to a natural rate of equilibrium. Instead of we have nations such as China which work to keep their currency artificially lower than would be the case where it left to float freely. We have the US engaging in Quantitative Easing so that it can weaken its own currency and thus perform an ipso facto default on the massive amount of debt it now owes. We have Brazil intervening in the currency markets regularly attemping to undercut the strength in the Real to aid them in retaining their share of the export markets. We have South Korea doing the same in regards to their Won, and thus the list goes on and on.

In such a fictitious world, one could make the argument that the Japanese Yen should be allowed to strengthen to aid Japan in its rebuilding efforts by making the cost of raw materials much cheaper. The reality however is that Japan must deal with the world as it now is, and not as we would like to see it. This is the reason that I must dismiss the idea that the Japanese should stand idly by and allow a massive unwinding of a leveraged carry trade take their currency to levels that would crush their export markets and render them unable to compete.

Let's begin therefore by admitting that I am complete agreement with those who claim that the Yen should be allowed to strengthen on this one condition - That the events of the last week had occured back in 2007 or 2008 when the Yen was at a significantly LOWER level on the crosses than it was this past week.

Please examine the long term chart of the Yen that I posted earlier here on my site (I am once again posting it here for your convenience). If you are to come away with only one point in this discussion, let it be this: THE JAPANESE YEN IS AT THE HIGHEST LEVEL AGAINST THE US DOLLAR IN MORE THAN 35 YEARS. It might be an even longer period; I simply do not have the chart data going back beyond the early 1970's.

My answer to those who insist that the Yen should be allowed to further strengthen, no matter what that will do to Japan's export-related industries, is that their argument has ALREADY taken effect. The YEN is not a weak currency under any method of looking at it when it is compared to the US Dollar. How could it be stated that the Japanese monetary authorities should let it rise even further and turn a blind eye to the actions of a runamok speculative short squeeze?

If you note the chart carefully, you can see that since the Yen carry trade began being unwound in mid 2008, the Yen has increased in value against the Dollar by nearly 40%! That is an astonishing rate of increase.

Now consider the following - The Dollar is still the world's reserve currency and as such most commodities are generally priced on the global market in terms of US Dollars. In effect that means if commodity prices had remained flat and gone nowhere in price since the fall of 2008, the Japanese would be able to purchase 40% more cotton, corn, copper, wheat, etc today for the same amount of Yen than they had been able to buy back in 2008. Here is exactly what those who are advocating for a stronger Yen are arguing. The problem however for Japan is that the same goods that the Japanese are attempting to sell to the US consumer market have now increased 40% if prices were to have remained at the same level that they were back in 2008. That puts the Japanese at a serious competitive disadvantage when dealing with other nations looking to sell their products to the US.

Consider also that while China has loosened its currency band to the point where the yuan has been able to strengthen some against the Dollar, it still maintains a sort of quasi-peg to the Dollar meaning that this gives Chinese manufacturers a decided advantage against Japanese exporters for US market share.

I realize that there are other nations and blocks out there such as the EU and the rising Latin American economies, but for the sake of simplicity I am only dealing with the China/Japan/US relation. Given this current level of the Yen therefore, and the loss of Japanese export competitiveness with China, I do not understand how some can assert that the Yen should be allowed to strengthen even further from current levels, especially given the fact that the Yen strength is not due to normal reasons but is instead the product of a speculative unwind of leveraged trades and in that case is abnormal.

Now let's take a look at a chart that many of you are now familiar with as I have been referring to it quite often over the last few years, namely the Continuous Commodity Index or CCI. Note the massive selloff in the CCI after it peaked in mid 2008 as the credit crisis erupted and the carry trade was unwound. That move towards risk aversion resulted in wholesale selling of commodities across the board.

As you can see the plunge in commodity prices did not stop until the Federal Reserve announced that it would soon commence a program known as Quantitative Easing. That had the immediate effect of launching a multi-year rally in commodity prices which took the index past the all time peak it had previously reached in the summer of 2008. As of the close of trading this Friday, March 18, the CCI is currently 7.8% higher than its peak of 2008. It is apparent that the Fed's efforts at staving off deflationary pressures has indeed been successful if you call a soaring of food prices and metal and energy prices "successful".

Now let's take a look at this same exact index although this time around let's view it through the prism of the Japanese Yen. In other words, we are going to adjust the chart to see the performance of the commodity sector when priced in terms of the Japanese Yen. Keep in mind that this speaks directly to the point of the fact that world commodity prices are quoted in terms of the US Dollar because it is the global reserve currency.

As you can see this chart looks vastly dissimiliar to the CCI chart above. While Dollar priced commodities are trading 7.8% higher than their peak level in 2008, Yen priced commodities are currently trading at a DISCOUNT of 18% to that same peak. In other words, because of the strength in the Yen, the Japanese economy has been somewhat inoculated from the soaring cost of commodities worldwide. They are actually buying commodities at a discount to what they were paying for them in 2008 even though the entire sector has been soaring into new highs ever since the Fed began its QE policies.

I point this out to say that the Yen is already trading at levels which are high enough to allow it purchase all the commodities it needs without having to suffer an inflationary impact on its own population. Furthering strengthening of the Yen would of course bring prices for commodities down even further if nothing else changed but any gains from that would be more than offset by a further weakening of the competitiveness of the Japanse exporters.

I would argue that the Japanese authorities could actually allow the Yen to weaken from its current levels without affecting them excessively when it comes to purchasing the raw materials and foods required for the rebuilding process. Many nations across the Pacific Rim are grappling with huge inflationary problems; Japan is not and that is mainly because its yen is already so overvalued.

What Japan is going to require more than anything right now is growth in its economy. If that segment of their economy which is so vital, namely their export related segment, is to remain competitive on the global markets, the Yen is too richly valued in my view to permit this. It will need to weaken to give their manufacturers a fighting chance agains the Dragon China and some of the other powerhouses of the region. There is plenty of room for the Yen to weaken and come down in value without feeding into the inflationary type spiral that one normally sees in a country whose currency is moving lower. If those who are advocating for a rising Yen had made this argument back in 2007 or even in early 2008, I would be squarely on their side. The fact that the Yen has risen 40% and higher since then makes their argument unconvincing especially in light of the current facts.

One last thing, a move by China to let the Yuan seeks its own level, free of any attempts to check its rise, would also work to help Japanese competitiveness not only with direct trade between those two nations but between Japan and the US. Such an event might make this entire discussion whether or not it was appropriate to intervene on the behalf of the surging Yen moot.

8 comments:

Dan,Excellent analysis. Very 1st chart should really be $/Yen as shown. I always look forward to reading your commentary on Jim Sinclair's site. He along with you are my true mentors and have made me a true believer in Gold. Keep up the good work.Hiren

Thank you for the post Dan. It is a very interesting way to look at the problem. One question that must be asked however is how effective the manipulation will be in the long run. Previous interventions by the BOJ lasted for shorter and shorter periods of time with each sequential attempt. Maybe this time will be different because of the bigger guns that were brought to bear.

Dan, your time and effort in further clarification of this topic is greatly appreciated. I guess your bottom line is that Schiff and Pento are in princple correct that the JPY should apppreciate, but the massive distortions in the market caused by the central banks and hedge funds have already effected the appreciation. Someone at GATA said there are no markets any more, only interventions - they were probably referring to gold and silver but it seems to be applicable to everything these days. What an incredible mess the world has become- just look at the volatiility in the charts. A number of prominent hedge funds have already given up. One can only hope that the other 99% will follow their example.

"If you are to come away with only one point in this discussion, let it be this: THE JAPANESE YEN IS AT THE HIGHEST LEVEL AGAINST THE US DOLLAR IN MORE THAN 35 YEARS. It might be an even longer period; I simply do not have the chart data going back beyond the early 1970's."

Dan, I attended a conference back in Nov 2010. One of the many speakers at this event presented a long term USDJPY chart (the converse to your JPYUSD chart but I'm not fussy).

One thing I noticed was that in the mid 1950's (around 55-56), the level of this cross was around 360-320 Yen to the Dollar. It was around the 200-300 range in the 60's decade.

You are correct in saying the highest level in "more than 35 years". However, it is more like the highest level in "more than 56 years".

Long term (and I'm talking half a century or more) the USDJPY chart I saw at this conference, which went back to about 1948, looks like a set of stairs going down into the basement. It's really an undeniable long term trend of Yen strength against the USD during that timeframe.

The Yen is at close to all time highs against the USD in more than half a century is a reasonable description to make of this currency cross' trend over the very long term.

Speaking of the real world here, I am just wondering what is entailed by Japan “growing” its economy? In terms of real world stuff, how specifically could Japan do this? Its population is decreasing, it has no more available land area to realistically increase agricultural output. And isn’t Japan already a manufacturing powerhouse on the cutting edge of modern technology? And aren’t energy prices going up, not only because of QE but because we are simply running out of fossil fuels?

I’d be careful listening to Peter Schiff, he has some math problems. He says that catching more fish makes them more abundant. Apparently the reason ocean fisheries, one after another, are in collapse around the world, is because we aren’t catching enough fish. The wonderful free market should sort all those problems out though, I guess.

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About Me

Dan Norcini is a professional off-the-floor commodities trader bringing more than 20 years experience in the markets to provide a trader’s insight and commentary on the day’s price action. His editorial contributions and supporting technical analysis charts cover a broad range of tradable entities including the precious metals and foreign exchange markets as well as the broader commodity world. He is a frequent contributor to both Reuters and Dow Jones as a market analyst for the livestock sector and can be on occasion be found as a source in the Wall Street Journal’s commodities section as well as CBS Marketwatch where his views on the gold market can often be found.
He is also an avid beekeeper.

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